Oh! What a lovely supermarket war

Last month Richard Goyder, the chief executive of Wesfarmers (ASX: WES), the owner of second-largest supermarket chain Coles, took aim at Aldi Australia. Goyder said: ‘I think someone should go and have a good look at how much tax Aldi pays in this country, because I suspect they’re very profitable’.

Aldi called his bluff last week in a submission to a Senate inquiry. The supposedly secretive company was a model of disclosure and revealed how much tax it has paid over the past four years.

Assuming the figures are correct, taxpayers should be jumping for joy. Not only has Aldi paid $238m in income tax over the four years to 31 December 2013, the average rate on pre-tax earnings has been almost 32% – above the 30% corporate tax rate.

Goyder is right about one thing: Aldi is very profitable. In 2013 the company earned a pre-tax profit of $261m, presumably justifying the parent company’s decision to enter the Australian market in 2001.

Don’t mention the war

Aldi is a privately-owned German company. We can’t own shares and, even if we could, they’d probably be highly priced. As investors, our interest is the implications of Aldi’s strategy for the Australian supermarket businesses we can buy shares in: Woolworths (ASX: WOW), Wesfarmers and Metcash (ASX: MTS), the distributor to the IGA supermarket brand.

Aldi’s submission to the Senate enquiry also helps here. You can see Aldi’s sales and margins over the past five years in Table 1. So what’s interesting?

Table 1: Aldi Australia profitability

Year to 31 Dec.

2010

2011

2012

2013

2014

Revenue ($m)

3,139

3,523

4,163

4,998

>6,000

Profit before tax ($m)

121

140

232

261

Not avail.

Pre-tax margin (%)

3.9%

4.0%

5.6%

5.2%

Not avail.

First, Aldi’s margins are perhaps higher than expected. The company’s low cost strategy means it can make decent margins on sales that are much lower than Woolworths and Coles (which have $41bn and $29bn in sales respectively). In fact, Aldi’s margins compare pretty favourably to Woolworths’ and Coles’ 2014 operating margins of 8.0% and 5.3%.

Second, sales have been growing strongly as Aldi’s store-opening program has ramped up. The company’s sales have virtually doubled over the past five years. Whilst a company with $3bn in sales wasn’t likely to trouble Woolworths or Coles much, a company with $6bn in sales is more of a threat. In other words, Aldi has reached critical mass.

Third, Aldi’s growth looks if anything to be accelerating. The company takes a very measured approach to expansion. Despite having been in Australia for 14 years, it has yet to enter the South Australian or Western Australian markets. The first stores are expected to open there in 2016.

This is particularly bad news for independent supermarket brands such as Metcash’s IGA, which have higher market shares in South Australia and Western Australia than they do in the eastern states. Metcash’s problems may not be over, with that company’s share price already down 71% since Intelligent Investor downgraded the stock to Sell in The Metcash earnings hole on 31 Aug 12 (Sell – $3.69).

Down, down, margins are down

Aldi’s numbers confirm that Woolworths has most to lose from greater competition in the Australian grocery market. With an operating margin of 8% and prices that customers now perceive as too high, it’s not hard to conclude Woolworths margins have to come down. Intelligent Investor has been saying exactly that for six months.

But at least Woolworths is not Metcash. Its very existence is not threatened. When Woolworths’ new chief executive comes in, he or she will presumably reinvest significant amounts in grocery prices. Such a strategy could keep Coles at bay and slow the drift of price-conscious customers to Aldi.

Woolworths’ margins will come down. And shareholders should prepare for some potential share price pain as the readjustment takes place (remembering that some of the pain has already been anticipated).

But with Woolworths, Coles and Aldi all making profit margins of more than 5%, the Australian grocery market looks completely rational. There might be some jockeying for position over the next few years but this is a profitable and attractive industry. Aldi’s margins prove the point.

Disclosure: Staff own shares in Woolworths and Wesfarmers but not the author, James Greenhalgh.

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